What Are Deferred Payment and Prepayment?
Accrual accounting recognizes that every sale includes two events, and these may not occur at the same time.
The Deferred Payment and Prepayment concepts allow buyers and sellers to record sales transactions "on the books" immediately when the transactions starts, keeping it in view continuously while waiting for the transaction to complete.
Define Deferred Payment and Prepayment
A Deferred Payment exists on the seller's books when the seller delivers goods and services, but then time passes before the customer pays for them.
- To accountants, a "fly now, pay later"plan is a a deferred payment plan.
- The "0% financing" offers that some auto dealers use as customer incentives are deferred payment plans.
The Prepayment situation exists on the buyer's books when a buyer pays first and significant time passes before the seller delivers goods and services.
- Tenants typically pay floor space rental fees, for instance, at or before each occupancy period.
- Insurance companies typically require premium payment before the coverage period starts.
Rental expense and insurance premium payments in such cases are thus prepayment situations for the buyer
Explaining Deferred Payment and Prepayment in Context
Sections below further define and explain deferred payment and prepayment in context with related terms from accrual accounting, emphasizing two themes:
- First, defining accrual accounting terms when sales actions include transactions occurring at different times: Deferred Payment, Accrued Expense, Accrued Revenue, Deferred Expense, and Unearned Revenue.
- Second, explaining how a sale with delivery of goods and services at one time, and payment at another time, creates temporary "Deferred" and "Accrued" account balances.
- What is unearned revenue (deferred revenue)?
- How does accrual accounting recognize revenues?
- Bookkeeping transactions for unearned revenue
- Explaining relationships between "unearned revenues," "deferred payments," and other accrual concepts
- Do unearned revenues exist with cash basis accounting?
- For an introduction to a broad range of accrual concepts, see Accrual Accounting.
- Double-Entry System explains the basic principles in double-entry accounting.
- Accrued Revenues explains that term and Accrued assets.
- Accrued Expense explains that term and Accrued liabilities.
How Does Accrual Accounting Recognize Revenues?
Why is the Role of the Matching Concept?
Most businesses worldwide implement accrual accounting with a double-entry accounting system. They choose this approach even though it is more complicated and more difficult to use than the more straightforward alternative, single entry accounting.
Using a double-entry system requires users to have at least a basic level of training in accounting. The double-entry user must, for example, have a solid grasp of concepts such as debit, credit, Chart of accounts, and the so-called Accounting equations. By contrast, just about anyone who can arrange numbers in a table and add and subtract can set up and use a single entry system.
Public companies and almost all large firms nevertheless choose double-entry and accrual accounting. They do so because it is nearly impossible for them to meet government reporting and record-keeping requirements using a single-entry system alone. And, they choose this approach because it enables them to track and manage revenues and expenses, as well as liabilities, owners equities, and assets. By contrast, Single entry accounting serves only for managing cash outflows and inflows.
Unearned Revenues Help Implement the Matching Concept
The unearned revenue concept serves to help firms turn cash payments into revenue earnings over time. In other words, with accrual accounting, customer prepayments do not become revenue earnings immediately. Regardless of when customers pay cash, revenues do not qualify as revenue earnings until the seller formally earns them by delivers the goods or services.
Unearned revenue serves in this way to apply a universal principle in accrual accounting—the matching concept. Matching means that:
- Firms report incoming revenues in the period they earn them.
- They match revenues by reporting in the same period the expenses they incur to earn them.
In brief, matching means reporting revenues matched with the expenses that brought them. In this way, the matching concept contributes to accuracy in reporting profits.
When Does Accrual Accounting Recognize Revenues?
In accrual accounting, sellers must, in fact, meet two conditions to recognize funds as revenue earnings.
- Sellers must deliver goods and services for the revenues.
- If the sale "closes," but before the customer pays, the seller can claim revenues earned if and only if the seller considers them to be realizable. In other words, the seller expects in fact to receive the cash payment.
The unearned revenue situation satisfies the second condition because the customer has already paid. In this situation, the seller claims revenue earnings when delivery occurs.
Bookkeeping Transactions for Unearned Revenues
When the firm first receives payment as unearned revenues, the bookkeeping journal transactions that follow depend on how long it will take to earn the income (complete delivery of goods and services). The critical question is whether or not "earning" occurs in the same period as payment.
Example 1. Recognizing Revenue for Same-Period Earnings
If goods or service delivery occurs in the near term, say, within a month and within the current accounting period, the firm treats the revenues as ordinary revenue earnings.
Consider a $500 purchase that begins with a customer cash payment. As a result, the seller debits an asset account.
- Here, the "debit" is a $500 increase in the account Cash. At the same time, the seller credits $500 to a revenue account.
- Here, the "credit" is a $500 increase to the account Product sales revenue.
|Exhibit 1. Journal entries for cash received and product sales revenue earnings.|
Example 2. Recognizing Revenues When Earning Occurs in a Later Period.
However, when it is clear that the revenue earnings will not complete for several months, or until the next accounting period, the journal transactions include a debit to an asset account and a credit to a liability account.
- Here, the "debit" is a $500 increase to the Cash account.
- And, the "credit" is a $500 increase to the Unearned revenue account.
These Journal transactions might look like this:
|Exhibit 2. Journal entries when the customer pays cash before the seller delivers goods or services.|
When the seller finally delivers goods or services, later, the firm recognizes revenue earnings with two adjusting entries in the journal:
- Firstly, a "debit" to the same liability account used earlier. Here, that is a $500 decrease in the "Unearned revenue" account.
- Secondly, a credit to a revenue account. Here that is a $500 increase In the "revenue" account "Product sales revenues."
These might appear as follows in the bookkeeper's journal:
Journal for Fiscal Year 20YY
250 Unearned revenue
|Exhibit 3. Journal entries after both sales transaction events. At this point, the customer has paid cash for the purchase, and the seller has delivered purchased goods and services.|
In practice, the firm makes another pair of entries—adjusting entries—during the accounting period, as it delivers goods and services. Accountants often wait until the end of the period to make these entries, when they must report Balance sheet accounts as they stand at the period end.
Unearned Revenues, Deferred Payments and Other Concepts
Firms manage unearned revenues with accrual accounting in much the same way they handle some other revenue and expense transactions when there is a time lapse between two parts of a business transaction.
- One part is the buyer payment
- The other part is the seller's delivery of goods and services
Both elements may happen at the same time, as in retail shopping. Or, either part may precede the other with a time lapse between them. For instance:
- Delivery occurs first when the customer buys using credit the seller issues.
- Payment occurs first when a traveler buys airline tickets on a "fly now, pay later" plan.
Because the matching concept mandates that firms recognize revenues in the same period with the expenses that brought them, prepayment and deferred payment situations present a particular challenge to the company's bookkeepers and accountants. This because it is possible for actual payment and actual delivery.
For compliance with the matching concept, both the seller and the buyer record the first part of the sale event, as it occurs, with two journal entries. Example journal entries of this kind appear above in Exhibit 1 and 2. Exhibit 2 represents such entries when there is a time lapse between parts sale parts 1 and 2.
Later, when part 2 of the sale occurs, the buyer and the seller each make another pair of journal entries, such as those shown in Exhibit 3. The seller cannot claim "revenue earnings," and the buyer cannot claim "expense payment," until both parts of the sale transaction complete.
Exhibit 4 summarizes the possible accounting results from a sale, after just one part of the two-part sale transaction takes place.
|AFTER SALES TRANSACTION PART I||Customer Pays Before Seller Delivers||Seller Delivers Before Customer Pays|
|The Seller Has:||"Unearned Revenue"
|The Buyer Has:||"Deferred Expense"
|Exhibit 4. Accrual accounting results after only one part of the sale transaction. The terms in each cell are interchangeable.|
Prepayment: Payment Precedes Delivery of Goods or Services
The prepayment situation occurs when customers pay before receiving goods or services. That is the unearned revenue situation, the subject of this article.
- From the seller's viewpoint
The seller recognizes "unearned revenues" (or "deferred revenues") as revenues received for goods and services not yet delivered.
The seller records unearned revenues as liabilities until delivery of the purchase. Only then do the funds become "revenue earnings" for the seller.
- From the buyer's viewpoint:
The buyer recognizes "deferred expenses" (or "prepaid expenses" or "deferred charges") when paying for services or goods before delivery.
- An inventory of postage stamps, bought but not yet used, is a "prepaid expense."
- When firms pay taxes before they are due, they create "prepaid expense."
- Buyers record "prepaid expenses" as assets until they receive the goods or use the services.
- For more on the "deferred expense" concept, see Deferred Expense.
Deferred Payment: Delivery of Goods or Services Precedes Payment
The "deferred payment" situation occurs when the seller delivers goods or services before the customer pays.
- From the seller's viewpoint:
In the deferred payment situation, the seller who has not yet been paid records "accrued revenues" (also called "accrued assets" or "unrealized revenues"). These are revenues earned by the seller for delivery of goods and services for which the seller has not yet received payment.
Sellers may post "accrued revenues" in an asset account, such as "Accounts receivable" until the customer pays cash. Then, the seller credits (reduces) Accounts receivable, while at the same time debiting (increasing) another asset account, Cash.
For more on the accrued revenue concept, see Accrued Revenue.
- From the buyer's viewpoint:
Buyers post "accrued expenses," or "accrued liabilities" in their books, registering their debt for goods and services purchases for which they must make payment.
- When employers owe their employees salaries or wages for work completed, but not paid them yet, the employer has an accrued expense.
- Interest payable for a bank loan can be an accrued expense. "Accrued expenses" first enter the journal as liabilities until paid, at which time the firm debits (reduces) a liability account, while crediting (decreasing) an asset account, such as "Cash on Hand."
- Firms first enter Accrued expenses
in the journal as liabilities until they pay them.
- Firms debit (reduce) a liability account when they pay.
- At the same time, they credit (decrease) an asset account such as Cash.
Exhibit 5, below, shows the results after the second sales transaction event.
|AFTER BOTH PARTS OF THE TRANSACTION||When Payment Precedes Delivery||When Delivery precedes Payment|
|The Seller Has:||"Sales Revenue earnings"||"Sales Revenue earnings"
|The Buyer Has:||"Expenses paid"||"Expenses paid"|
|Exhibit 5. Accrual accounting results after the second sales transaction event.|